Risky Business: Comparing Appetite for Risk with Rates of Return

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The more time I spend in the industry of valuation, I often find myself trying to nail down the fifteen second description of what we do and how the value of closely held companies is determined, as I get that question quite often and no one has a spare half-day to discuss the topic. When I say closely held, I mean companies owned by a relatively small group of people.

Simply put in my own words, the value of a business is at the intersection of two main roads: 1) the expectation of future economic benefits, and 2) the probability (and risk) of those benefits coming to (or not coming to) fruition in that estimated timeframe. In other words, the present value of the future cash flows of the company, discounted at a rate of return reflective of the risk attributed to that company. Of course, this is the oversimplified description, but it is often beneficial in this field to get out of the weeds and really think about the purpose of what we are trying to accomplish in a valuation. As an investor, one should consider how much cash flow they want back from an investment, and what rate of return do they require in order to achieve that cash flow. If these two things are known, then theoretically one can derive the value of that asset, at least in one’s own eyes.

Risk is one of those business buzzwords that it feels like gets tossed around often without discussing what is meant by it. In short, risk is a chance of loss. In life, it is the chance the harm will come your way. In valuation, it could be viewed as the chance of a forecasted event not occurring or occurring in a way that is substantially different from what was expected (usually in a bad way). In a nutshell, when it comes to business, risk is the chance of losing one’s money.

In business valuation, risk is typically quantified through what is called a discount rate. The discount rate is a rate of return required to achieve a specified level of benefits at some point in the future. It is measured depending on the level of risk involved with a company, as determined by an investor, valuator, or other user of the information. The riskier the company, the higher the required rate of return on investment (i.e., discount rate). Professional valuators quantify the discount rate through several methods, but a widely accepted method involves building up the discount rate above the risk-free rate, which is widely accepted as a long-term Treasury Bill rate, more specifically, it is usually the 20-year Treasury Bill rate. For each additional “layer” of risk, a percentage amount is added to the risk-free rate until finally arriving at the discount rate. Additional layers of risk are added for an equity investment premium, a small company risk premium (risk due to the smaller size of the subject company), industry risk premium (risk present due to operating in a certain industry), and additional risk specific to the Company as determined by the professional (typically derived through analysis of the company and its condition). Another term you may hear is capitalization rate, which is the discount rate adjusted for long-term growth.

Valuation of closely held entities is largely reliant on the idea of alternative investments. In other words, what is the rate of return on alternative investments and how do they compare to a particular company. Some examples of safer alternative investments to equity investments in private companies are Treasury Bills, mutual funds, index funds, and municipal bonds, etc. Some examples of riskier investments include options, oil and gas wells, high-yield bonds (or junk bonds), venture capital projects and start-up companies. Different small businesses have different levels of risk. For example, restaurants are an example of a small business that is also one of the riskiest small business investments one can make, with about two-thirds failing in the first year.

Let’s look at an example. I have $100,000 to invest any way I choose. I have a friend who is a financial advisor telling me to put $100,000 into a 10-Year Treasury Bill. He says, “The return is virtually guaranteed. The government is always going to pay its Treasury Bill obligations. It is very safe.” However, I notice that the rate of return is only 2.00%. Do I really want to tie up $100,000 of my funds for 10 years only to earn 2% by the end of it? Perhaps I do, depending on my risk appetite, but let us also consider a friend who is a passionate and promising chef and wants to start his or her own restaurant, and they are looking for backers. As a prudent investor, knowing what I know about restaurants, I am going to demand a much higher rate of return on my $100,000 than 2.00%, as I am putting my funds at a much higher risk than if I were investing in a Treasury Bill. There is also no guarantee as to when or how much I will be paid (if I am ever paid). The required rate of return could be as high as 20%, 30%, or even higher. It all comes back to risk versus return.

The required rate of return and measurement of risk is really a matter of judgment for an investor, but one might consider the current rates for Treasury Bills, the expected return for the DJIA, S&P 500, or an index fund, or some other measure in forming the starting point in estimating the required rate of return for a private equity investment. The question is, how much more return would a potential investor demand in exchange for investing in a much riskier investment? This is a very complex and subjective determination, and a certified valuator has the knowledge and resources to assist with such considerations to advise you on a best path forward. Speak with us to gain insight on the various risk factors affecting the value of your company in an investor’s eyes.